Capital rationing definition
/What is Capital Rationing?
Capital rationing is the decision process used to select capital projects when there is a limited amount of funding available. This can occur when a business is unable to obtaining funding from outside sources at a reasonable price, or when management decides to allocate available funds to other purposes, such as the payment of dividends to investors. Rationing may also be imposed when there is enough funding, but management is restricting it from certain parts of the business in order to emphasize investments in other areas. There are a number of ways to engage in capital rationing, including the following:
Focus on highest returns. Management could allocate funding just to those areas most likely to generate the highest returns. A variation is to apply a higher cost of capital to net present value calculations to strip away lower-return projects. This approach improves short-term profits, but may not enhance profits over the long-term, since it ignores strategic changes that may require long-term investments.
Focus on strategy. Management could channel funding toward strategically important areas. Doing so provides good long-term competitive positioning for the business, but possibly at the cost of a short-term decline in profits.
Focus on throughput. Management could focus funding on bottleneck operations to enhance throughput. Doing so increases the capacity of the bottleneck operation, making it easier to meet order commitments made to customers. A beneficial side-effect of this approach is that the business will then spin off more cash, which may subsequently ease the capital rationing situation.
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Types of Capital Rationing
There are two types of capital rationing, which are hard capital rationing and soft capital rationing. We describe these concepts below.
Hard Capital Rationing
Hard capital rationing occurs when external factors limit the funds available for investment. This typically happens when a company faces restrictions from external sources such as lenders, investors, or capital markets. For example, banks may limit credit due to the company’s weak credit rating, or the company may be unable to issue new shares or bonds because of poor market conditions. In hard capital rationing, the shortage of funds is beyond the control of management, forcing the company to prioritize only the most essential and profitable projects. Hard capital rationing is common during economic downturns or periods of financial instability.
Soft Capital Rationing
Soft capital rationing happens when a company internally limits its investment budget, even if external funds are available. This is usually a management-imposed restriction due to strategic considerations, risk management, or conservative financial policies. For instance, a company may deliberately cap its capital expenditures to avoid overexpansion, maintain debt levels, or focus on only the most strategically aligned projects. Soft capital rationing is more flexible than hard capital rationing, as management can adjust the capital budget depending on changing priorities or improved financial performance. It reflects a company’s cautious approach to financial planning rather than an actual shortage of funds.